Mar 27, 2011

More and more we actuaries and risk managers become aware that our risk models can't just be based on numbers and statistics exclusively.

Some examples:

Systemic risk

The recent financial crisis made it clear that a 'mono risk approach' on a sole risk-object (mortgage, fund-investment) is insufficient.

Investments and loans are embedded in a worldwide sea of connected financial instruments and reinvestments. Systemic risk has to be included in our models.

Main challenge here is that systematic risk essentially depends on macroeconomic and (mostly) irrational factors. Further, systemic risk is related to the structure and dynamics of the market. More than numbers.....

Supervisory Herding Risk

In their effort to control and support financial institutions like banks, pension funds and insurance companies, country supervisors, regulators and 'accounting standards boards', defined a meticulously set of guidance rules (Basel I/II/II, Solvency I/II, Qis-I-V, IFRS, FAS, AIFMD, FTK, FIRM, etc.,etc.)

Financial institutions not only confirmed and adopted to those new rules, but - in their rush and driven by cost and time pressure - also implicitly (and often unintentionally) declared those same imposed rules and rationales as their own business 'Risk Appetite'. This way, most financial Institutions became so called: 'Supervisory Compliant'.

Instead of expliciting their specific company-targets and successively developing their own correspondent risk appetite and risk framework, they incorporated the supervisor's risk philosophy.

Without a sound own (board) risk vision that would undoubtedly have included some extra safety on 'company specific risk issues', financial institutions became - like a herd - all in the same way extremely vulnerable to (less defined) external risks.

Summarized:

Overregulation increases Herding Risk

Financial institutions all measure and respond to regulated risks in the same way. Supervisory Herding Risk is born.....

Too Much Focus Risk

As a consequence of pre-subscribed risk categories and ruling by law or (accounting) standards, there's the risk of 'too much focus' on specific risks while forgetting, denying or neglecting other important risks. Remember, the devil is in the (correlating) details....

Here's a useful, but not exhaustive, checklist to keep track on your risk models...

Average Premium Risk

Diversification Risk

Matching Risk

Commodity risk

Employer Continuity Risk

Operational risk

Compliance Risk

Environmental Risk

Outsourcing Risk

Compliance Risk

Equity Risk

Oversight Risk

Concentration Risk

Herding Risk

Price Inflation Risk

Counterparty Risk

Interest rate risk

Property Derivatives Risk

Coverage Ratio Risk

IT Risk

Reinsurance Risk

Credit Risk

Legal risk

Reinvestment risk

Culture Risk

Legislative Risk

Reputation risk

Currency Risk

Liability Risk

Sex Calculation risk

Default Risk

Liquidity risk

Strategic risk

Deflation risk

Longevity Risk

System Risk

Disaster Risk

Market Risk

Systemic Risk

Discount Risk

Matching Risk

Wage Cost Inflation Risk

ALM Simplifying Risk

Univariate models are killing and even multivariate models have proven to be too vulnerable and too limited in the recent crisis. It's not just about correlation and covariance matrices. What we need is an self-explaining model. A model that predicts or generates expected values in an economic context, depending on exogenous economic variables like inflation rate, GDP-Level, etc. and that is based on the same structured historical economic data-set.

We need 'Asset Liability Modeling New Style' and not only Stress Testing or
advanced and excellent Crash Modelling as well explained by EMB.

Geopolitical Risk

With Europe and Japan as recent examples, it's clear that risks come from everywhere around the world.

More than just trying to catch and capitalize these kind of risks in our risk models, we need to develop (financial) mechanisms and products that can cope as best as possible with these kind of risks.

The Riskmap 2011, Managing Risk | Maximising Opportunity, offers a good description of the actual risks that influence our lives and risk models.

A nice example is the recent (unexpected) leading role that France took in action against Libya. 'Riskmap 2011' mentions the 'Arabic Poll 2010' that clearly shows (despite the lack of sympathy for president Sarkozy) the trust and sympathy for France. France clearly outperforms the US and president Obama unfortunately has lost the trust of the Arabic world... Take a look at the next slide summary (or the original complete pdf):

The Arabic poll shows that the prime minister of Turkey, Erdogan, has clearly gained the confidence and trust of the Arabic countries. With Ergodan, Turkey - at the cross road between East and West - takes a leading role in the 'World Risk Management Process'. Ergodan's Risk Philosophy, invented by the Turkish Foreign Minister Ahmet Davutoglu, is 'Zero Problems'.....

Perhaps that should be the philosophy of actuaries too...

Zero Problems

Conclusion

From now on 'Modeling Risk' is more than just a financial exercise.
It's building scenario's, mechanisms and products that can cope with this risky world. Success as actuary or risk manager!

Mar 16, 2011

With all due respect for the Japanese risk managers, engineers and the Japanese people in general: The latest 2011 M=8.9 Earthquake in Japan made clear that the current Risk Models, as well as Risk Management itself, have tragically failed.

Shortcomings
Shortcomings in headlines:

Underestimation of the probability of a M=8.9 (M>8) event

Risk Modeling mainly focused on 'direct' earthquake effects

Underestimation of cumulative correlated devastating effects that occurred as a consequence of a combination of Earthquakes, Tsunamis, Nuclear Disasters and Physical Concentration (4 reactors in a row!).

Frequency?
It's true, the worldwide annual frequency of a serious earthquake with a magnitude of 8 or more (M>8) seems small....

Yet - no matter how low the probability- the consequences (loss) is unacceptable if the damage in case of an event (like an earthquake M>8) is not manageable, exceeds a country's financial recuperation power, or devastates thousands of lives...

End of Time?

Lots of worrywarts think the end of time has come, as severe earthquakes are increasing.

Simple statistics show that this is not (yet ?) the case:

The expected average Magnitude value of all earthquakes with M>=7 over the period 1950-2011 (March) is Ma=7.6 with a standard deviation of SD= 0.4. The average value of the last 10 years turns out Ma=7.4 with the same SD (0.4).

Nevertheless, when we examine the graphic more closely, there seems a light (significant?) increase in large magnitude earthquakes in recent decades.....

Back to the year 0
For what it's worth, the average magnitude for M>=7 earthquakes over a longer period from 0 to 2011 (March) , turns out in line with Ma=7.6 and a SD=0.44. Or in graphics:

History Earthquakes in GoogeMaps
Finally, take a look at the history of all earthquakes with a magnitude of 7 or higher on GoogleMaps... (take look at your country!)

IMF’s ability to detect important vulnerabilities and risks and alert the membership, was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed.

The IMF’s ability to correctly identify the escalating risks was hindered by:

IMF suggests some recommendations on how to strengthen its ability to discern risks and vulnerabilities and to warn in the future. Main point is to enhance the effectiveness of surveillance: it is critical to clarify the roles and responsibilities of the Board, Management, and senior staff, and to establish a clear accountability framework.

Looking forward, IMF needs to

Create an environment that encourages candor and considers dissenting views

Modify incentives to “speak truth to power”

Better integrate macroeconomic and financial sector issues

Overcome the silo mentality and insular culture; Deliver a clear, consistent message on the global outlook and risks.

Recognize Groupthink
Groupthink is not just something happening to IMF or 'other organisations'. We, financial institutions, all suffer somehow or somewhat from the Groupthink Virus.

How can we recognize Groupthink?
Derived from an article by Irving Janis, the inventor of the word Groupthink, let's take a look at some explicit signs of Groupthink:

Winning Mood syndrome
A common illusion of success (Folie à deux), invulnerability, over-optimism, unanimity and risk-taking as a consequence.

Collective rationalization
Managers, employees discount warnings and do not reconsider their assumptions

Repression or Ridicule
Direct pressure on and ridicule of individuals who express disagreement with or doubt about the majority view or the view of the leader

Fear
Fear of disapproval for deviating from the group consensus. Fear from or doubt about expressing your opinion.

Manipulating
Remaining silent in a discussion is implicitly interpreted as agreeing.Obviously 'wrong' arguments are used to achieve a certain goal or policy.

Disrespect
Stereotyped views of out-groups or enemy leaders as evil, weak or stupid. Good or serious ideas of colleagues are rejected on basis of the source instead of 'judged by the facts'.

Moral Blindness
Unquestioned belief in the inherent morality of the in-group. Lack of discussion about ethical or moral aspects of certain decision.

Miscommunication and Misinformation
Information, bottom up or top-down is (deliberately) strongly filtered

Idolization
Idolization of the leader or of certain five star employees.

Lessons Learned
If you recognize some of the above signs in your organization, it is time for action.
Discuss it, do not accept it and if you cannot change it... LEAVE!

A humorous example of Misinformation are the quotes of Iraq's minister of (Mis)Informaton, Al-Sahaf, during the 2003 Iraq war.
Enjoy, laugh and learn.....

Make sure your board presentation is not based on' sahaf-statements' but on simple provable actuarial facts....

Mar 6, 2011

For those of you that -just like me - didn't know that Bill Gates is actually a qualified actuary....

Bill Gates.., a man with a great vision and the same size of philanthropic heart. More information about Bill on the 'Bill and Mellinda Foundation' website, were another actuarial statement is launched:

Mar 5, 2011

Risk management is tricky business... Being 'Officially Compliant', 'Just Compliant' or in other words "Supervisory Compliant", is not enough to help your CEO survive with your company in the complex market battle!

Whether you're an Actuary or Risk Manager of an Insurance company, Bank or a Pension Fund, the risk of being 'Supervisory Compliant' is simply : bankruptcy!

Becoming 'Supervisory Compliant' in complex programs like Solvency-II, Basel III or Legal Pension Fund Risk Frameworks, consumes so much time and effort, that almost no time seems to be left for contemplating or doing the essential Risk Management work properly.

Just being 'Supervisory Compliant' implies: constantly running after the Supervisor to become 'just in time' officially compliant and not having enough time to think about the (f)actual relevant risks.

Supervisory Compliance becomes very frighting when Risk Appetite and Valuations are rashly based upon the minimum Supervisory requirements, as is (e.g.) the case in the Dutch Pension Fund legal framework. Boards stop thinking about the actual risks and feel compliant and satisfied once the Supervisory Compliance Boxes are checked.

A new look at compliance
Let's take a look from a new point of view at the complete Risk Management Compliance Field:

Professional Compliant
You comply to your own professional Risk Management standards. You are happy... but what about your Supervisor? Comply or Explain....

Success Compliant
Being Success Compliant implies that all Risk Management requirements that are key to have success - e.g. key to survive in the market on the long run - are met.

Let's zoom in at some specific areas in this chart:

Bias areas

It's perhaps hard to admit, but in our attempt to be complete, we define and manage a lot of (small) risks that do actually exist, but are in fact not really or limited relevant with regard to company continuity.

Distinctive Character area

The Distinctive Character area is perhaps the most interesting area. To get grip on this area urges us to 'Think outside the Circle'.

By doing so we'll be able to manage risks that our competitors fail to do. Here we can achieve 'Distinctive Character' by managing risks more efficient or by turning risks into profits. Examples are: Derivatives that limit our investment risks. Specialized experience rating (rate making) on your portfolio on basis of characteristic and unique risk profiles.

Tricky area
The tricky area is the area that consists of Supervisory Risks you tend not to find important, but that are very important for achieving success in the market. Tricky areas could e.g. be: Deflation Risk, Longevity Risk or Take Over Risk.

Reversed Thinking areaThis is perhaps the most interesting risk area.

To explore this area you'll not only have to 'think outside of your circle', but - just like in reversed stress tests with Banks - try to think backwards, to find out what could cause a certain event or loss.

This reversed thinking process succeeds best as a group. Group members should be professionals and non-professionals from different types of business, education and background.

A successful group mix could e.g. consist of : an actuary, an accountant, a manager, a marketing manager, a compliance officer, an employee, a client, a shareholder representative and last but not least the receptionist.

Finally.....
Try to find time to manage your company to new heights and stop being just 'Supervisory Compliant'.....

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

Nothing written here, or in my writings at Actuary-Info is an invitation to undertake whatsoever action, in particular to buy or sell any particular security; at most, Maggid is handing out educated guesses as to what the markets may do. Maggid thinks that "The markets always find a new way to make a fool out of you", and so he encourages caution with every action, in particular in investing. Risk control wins the game in the long run, not bold moves.

Additionally, Maggid may occasionally write about accounting, actuarial, insurance, and tax or other specialized topics, but nothing written here or on Actuary-Info is meant to be a formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that Maggid can have no knowledge of.

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